How far off is Sino Biopharmaceutical Limited (HKG:1177) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Step by step through the calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF (CN¥, Millions)||CN¥5.48b||CN¥6.26b||CN¥6.74b||CN¥7.13b||CN¥7.43b||CN¥7.68b||CN¥7.89b||CN¥8.09b||CN¥8.27b||CN¥8.44b|
|Growth Rate Estimate Source||Analyst x9||Analyst x7||Analyst x1||Analyst x1||Est @ 4.1%||Est @ 3.36%||Est @ 2.84%||Est @ 2.48%||Est @ 2.23%||Est @ 2.05%|
|Present Value (CN¥, Millions) Discounted @ 7.4%||CN¥5.1k||CN¥5.4k||CN¥5.4k||CN¥5.4k||CN¥5.2k||CN¥5.0k||CN¥4.8k||CN¥4.6k||CN¥4.3k||CN¥4.1k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥49b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.6%. We discount the terminal cash flows to today’s value at a cost of equity of 7.4%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CN¥8.4b× (1 + 1.6%) ÷ (7.4%– 1.6%) = CN¥148b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥148b÷ ( 1 + 7.4%)10= CN¥72b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥122b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$9.7, the company appears potentially overvalued at the time of writing. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don’t agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Sino Biopharmaceutical as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 7.4%, which is based on a levered beta of 0.812. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, the DCF calculation ideally won’t be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value lower than the current share price? For Sino Biopharmaceutical, we’ve compiled three further elements you should further examine:
- Risks: As an example, we’ve found 2 warning signs for Sino Biopharmaceutical that you need to consider before investing here.
- Future Earnings: How does 1177’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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